Assessing Eastern Europe's Capital Needs

The paper aims at assessing the capital needs of Eastern Europe in catching up to EC standards of living using the framework of a CES (constant elasticity of substitution) production function model. This function, parameterized on the EC, is assumed to apply with certain inefficiency factors in Eastern Europe in 1992. Quantitative results, given the heroic set of assumptions required, are bounded by large ranges. The approach provides a framework for assessing the factors which will determine the future capital needs in Eastern Europe and underscores the crucial role of efficiency gains in this process.


The paper aims at assessing the capital needs of Eastern Europe in catching up to EC standards of living using the framework of a CES (constant elasticity of substitution) production function model. This function, parameterized on the EC, is assumed to apply with certain inefficiency factors in Eastern Europe in 1992. Quantitative results, given the heroic set of assumptions required, are bounded by large ranges. The approach provides a framework for assessing the factors which will determine the future capital needs in Eastern Europe and underscores the crucial role of efficiency gains in this process.

Assessing Eastern Europe’s Capital Needs 1/ 2/

1. Introduction

The paper aims at assessing the capital needs of Eastern Europe in approaching EC standards of living. The methodology is the framework of an assumed western constant elasticity of substitution (CES) production function, parameterized on the EC. This function is assumed to apply, with certain inefficiency factors, to Eastern Europe in 1992. Using purchasing power parity (PPP) estimates, an initial position for Eastern Europe is derived for 1992, including estimates of the starting capital stock. The model then illustrates the capital needed to achieve the postulated growth--12 1/2 percent per annum for East Europe as a whole--on certain assumptions. A particular focus is the potential role of efficiency gains in this process.

2. Methodology and Initial 1992 Position

The basic approach is to characterize supply conditions in Eastern Europe in 1992 by a western-style production function. 3/ 4/ This is a constant elasticity of substitution (CES) production function. It links productivity growth to capital accumulation and improvements in the efficiency of the utilization of labor and capital services. Annex 1 provides a detailed description of the CES production function model. A series of assumptions are required to apply this model to Eastern Europe. Central assumptions--on output, capital stock and inefficiency parameters are discussed below. Other assumptions are detailed in Annex II and summarized below.

a. Output

The aim is to value Eastern European countries’ output in 1992 so that (1) the GDP per capita and (2) the resulting capital stock generated by the model is comparable with the EC. Purchasing power parity (PPP) exchange rates were thought to meet best these twin objectives. PPP projections were based on estimates of both PlanEcon and the CIA 5/; inevitably, these PPP projections are highly uncertain. In all countries, the projected PPP exchange rate is considerably more appreciated than projected 1992 official exchange rates. Projected GDP per capita using PPP exchange rates varies from US$2,800 in Romania (14 percent of EC 1992 average) to US$8,400 in Czechoslovakia (41 percent of EC average) (Table 1). On projected official exchange rates, the GDP per capita of Eastern Europe as a whole is around 10 percent of the 1992 EC average; on PPP rates it is slightly over 20 percent.

Table 1.

Eastern Europe: GDP Per Capita Targets for 2002

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Purchasing power parity.

EC average per capita income in 2002 was projected at US$25,530 (in 1992 U.S. dollars).

Over the projection period, it would be expected that the PPP and official exchange rates should converge. This is a normal feature of development. It is particularly likely as Eastern Europe integrates into the world economy, inappropriate structures are phased out and subsidies are reduced 1/--all of which are likely to be accompanied by an appreciation of the real (actual) exchange rate. No change in the 1992 PPP rates is assumed in the projections. However, the use of PPP exchange rates gives rise to two problems of interpretation of the results. First, investment ratios to national income (GDP) are calculated on PPP rates, well above current market rates. Second, to the (large) extent that investment goods will have to be procured from the west, these goods will not be purchasable at PPP but rather actual exchange rates. Calculating their economic cost (consumption foregone or external financing requirement) implicitly at PPP rates amounts to a significant understatement. 2/

The GDP projections for 1992 make some allowance for a recovery of CMEA trade from the depressed levels of 1991. Based on these projections converted at PPP exchange rates, and the projections of population growth, GDP per capita levels were derived. From these levels, targets were postulated for each Eastern European country in relation to the projected EC average GDP per capita (Table 1). For Czechoslovakia and Hungary, a target of two thirds of the projected EC average was chosen; for Bulgaria, Poland and Romania, the target was one half; the average for the region as a whole is around 54 percent. The resulting required annual growth rates of GDP (allowing for population growth) range from 7.7 percent per annum in Czechoslovakia to 17 percent in Romania; for the region as a whole the rate is 12 1/2 percent.

b. Capital stock and inefficiency parameters

No attempt has been made to estimate the capital stock from existing East European data. This is because the concept sought is capital which is usable in a western-style production function. The relationship between this concept and actual capital stock in Eastern Europe 1/ is obscure. 2/ Rather the approach adopted is to define the remaining parameters of the model for Eastern Europe and solve for the initial capital stock. 3/

Aside from the initial capital stock, there are three factors which are required, namely, the elasticity of labor services with respect to the capital output ratio (f) and the two efficiency parameters--general factor efficiency (g) and labor-specific efficiency (h). Factor (f)--the degree to which technical progress is embodied in capital accumulation--was assumed to be 0.5 based on the general proposition that half technical progress is embodied in capital accumulation. The general efficiency parameter (g) reflects the absence of a well functioning system of capital allocation and poor management. It affects both capital and labor. The labor-specific efficiency parameter (h) reflects labor hoarding, fostered by the traditional policy in Eastern Europe of preserving employment. Two efficiency factors are used to permit different inefficiencies in the provision of labor and capital services. The attachment of the specific efficiency factor to labor services reflects the widespread prevalence of labor hoarding and the greater potential mobility of labor than capital. Thus part of the inappropriate allocation of capital is unavoidably reflected in the valuation of capital and not in its inefficiency. Part of the existing inefficiency of capital use in Eastern Europe is reflected in a lower capital stock (valued for western production purposes) and part in continuing inefficient use (g).

There is no basis for deciding on the initial level of (g) or (h). Fixing one parameter, given the assumptions made to here, determines the level of the other. Given output, the share of labor and the size of the labor force, the effective use of labor and capital services is constrained so that a higher value of (g) implies a lower value of (h) and vice versa. The higher the level of (g), the lower the level of the initial capital stock, as the same capital services can be provided by a lower capital stock. 1/

On the basis of the following specific assumptions 2/ 3/:

  • - σ (elasticity of substitution between capital and labor services) = 0.5

  • - PL and PK parameter values derived from the EC

  • - NDP equals 0.8 1992 projected GDP valued at PPP exchange rates

  • - Labor share (in NDP) 0.7

  • - f (elasticity of labor services with respect to the capital/output ratio) = 0.5

and assuming neither (g) nor (h) exceed 1 (the EC level), the initial capital stock for Eastern Europe as a whole would lie in the range US$2.6 trillion (g = 0.325) to US$0.8 trillion (g - 1). In practice, the extremes of this range would appear implausible. It would seem inherently unlikely that the efficiency of capital use would approach EC levels 4/ given the pervasiveness of the legacy of central planning. The implication of (h) approaching 1 is that a specific labor efficiency factor is not warranted. From the argument advanced earlier--given the write down of existing capital--this seems improbable. In the absence of a sound basis for setting these efficiency parameters, the basic approach adopted is to set (g) equal to (h). This, admittedly arbitrary, assumption avoids the arbitrary imposition of values for either (g) or (h). The efficiency of capital use (g) is assumed to be greater than the efficiency of labor use (g x h). This is consistent with the approach adopted under which the existing capital stock has been “written down” to levels consistent with a western production function; no such adjustment has been made (for obvious reasons) to the stock of labor. The 1992 position of Eastern Europe based on this assumption is shown in Table 2.

Table 2.

Eastern Europe Initial Position - (1992) 1/

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Assumptions: σ = 0.5

f = 0.5

Labor share = 0.7

g - h

Output per worker.

Relative productivity for Eastern Europe as a whole (output per worker) is 21 percent of the EC average--ranging from 13 percent in Romania to 35 percent in Czechoslovakia. 1/ This lower relative productivity results from three factors namely the lower capital/labor ratio in Eastern Europe compared to the EC, the general efficiency in the use of factors (g), and the labor specific efficiency factor (h). The value of (g = h) under the equality condition, follows the same ranking--from 0.5 in Romania to 0.77 in Czechoslovakia as does the capital/labor ratio relative to the EC average. 2/ The “usable” capital stock for the region as a whole is estimated at US$1.3 trillion. 3/

3. Projections to 2002

In addition to the assumptions summarized under the initial position, various other assumptions are required. The labor force projections are described in Annex II. No change in the elasticity of labor services with respect to the capital/output rate (f) is assumed. The depreciation rate is assumed to be a constant 6 percent. 4/ No explicit allowance has been made for the vintage effect--that Eastern Europe’s capital stock, particularly under the high investment scenarios, will be newer and therefore arguably more productive than the capital stock in the EC. 5/ One percent annual growth in output is assumed to occur exogenously, while the remainder of the target growth rate is generated by endogenous factors. 1/ The capital/labor ratio in the EC is assumed to increase by 3 percent per annum. No change in the efficiency of factor use within the EC is assumed. 2/ The target growth rates described earlier (Table 1) are taken as given. Both required growth rates and projected efficiency gains (movements in g and h) are assumed to be linear within the projection period (1992-2002). On the basis of these assumptions, capital needs are generated consistent with various efficiency improvements. These are capital needs related to production: no attempt has been made to assess investment required for other purposes such as environmental clean up.

a. Efficiency gains

Given these assumptions, a striking result of the model is the importance of efficiency gains i.e. movements in the efficiency factors (g and h) from their 1992 position. For Eastern Europe as a whole, with no changes in these efficiency factors, cumulative investment of US$17 trillion 3/ would be required to achieve the growth target of 12 1/2 percent per annum. This would require investment/income (GDP) ratios well in excess of 100 percent, a capital/labor ratio nearly double the projected 2002 EC level (reflecting the continued inefficient use of capital) with extremely low rates of return to capital. This is clearly an implausible scenario. At the other end of the range, cumulative investment needs would be around US$2 1/2 trillion if EC efficiency levels could be achieved by 2002. Investment/income ratios would vary around 30 percent, while the required 2002 capital/labor ratio would be less than two-fifths the EC level.

By contrast, the impact of the starting position on cumulative investment needs is much less pronounced. Thus, if labor is efficient to begin with (h = 1), but a similar increase in (g) and (h) is assumed to 2002 4/, both the initial capital stock and cumulative investment needs are highest at US$2.6 trillion and US$7.4 trillion, respectively. If, at the other extreme, all inefficiency is attributed to labor (g = 1), the initial capital stock is US$0.8 trillion and cumulative investment needs US$4.8 trillion. The first scenario, with a high initial capital stock, would imply a crucial role in generating growth for improvements in general efficiency (g). Under the second scenario, with a much lower initial capital stock, future investment levels could be considered the crucial determinant of growth, given the shortage of initial capital. While large improvements in labor efficiency (h) would also be crucial, 1/ these would, in part, be determined by investment levels.

A key question is therefore the efficiency improvements that can be expected in Eastern Europe. Clearly movements in the efficiency factors (g and h) are a function of the reform policies pursued. Improvements in efficiency essentially are likely to result from liberalizing markets (improving factor allocation), establishing effective ownership (privatization), institution building in such areas as legal, statistical, accounting and banking systems, establishing local administrations and human and physical capital formation. It would not appear unduly optimistic to expect the bulk of the benefits from liberalizing markets and establishing effective ownership to be achieved by 2002--though the ownership structure may still differ substantially from that of most EC countries. It may also be the case that most institution--building will be completed by 2002, though it is perhaps questionable whether these institutions will be functioning to EC standards of effectiveness. In part this is a reflection of the fact that accumulation of human capital in such areas as the law, accounting, customer service, product innovation, management, marketing and banking--necessary to breathe life into the new institutional framework--takes years. Equally, the removal of infrastructural impediments is likely to be a lengthy process, extending beyond 2002. 2/

This qualitative discussion suggests that, not surprisingly, it would appear reasonable to expect major efficiency gains over the projection period, but that complete elimination of all inefficiencies is unlikely. On the assumption that half the current efficiency gap can be eliminated by 2002, cumulative investment needs are around US$6.5 trillion for Eastern Europe as a whole with investment/income ratios from 65-82 percent. By 2002, the capital/labor ratio has reached around 80 percent of the EC average and the real rate of return to capital has declined to 3 percent. If three quarters of the current efficiency gap can be eliminated by 2002, cumulative investment needs decline to US$4.2 trillion, with investment/income ratios around 50 percent. The capital/labor ratio rises to slightly above half the EC level while the real rate of return on capital declines to 5 1/2 percent. The first scenario is clearly less plausible than the second scenario: it is not plausible to envisage investment/income ratios of over 70 percent with real rates of return below 5 percent in the second half of the decade. In effect, the growth rates targeted are not achievable unless faster efficiency gains can be obtained than a narrowing of the current efficiency gap by one half.

Table 3 indicates the impact on a country by country basis of achieving current EC average levels of efficiency by 2002 and contrasts this with a more modest efficiency improvement of slightly more than a half. Overall, cumulative investment needs are less than half with the more rapid efficiency gain. For the current less efficient countries--Bulgaria, Poland and Romania--where EC catch up implies a particularly rapid efficiency gain--investment needs are less than one-third the level required with the slower efficiency improvement. In consequence, investment/income ratios fall dramatically from the 80 to 100 percent range to the 20-50 percent range. Similarly, capital/labor ratios for these three countries rise to around one third of the projected EC level by 2002 rather than over four fifths.

Table 3.

Eastern Europe: 2002 Projections. Elimination of One Half, Ail 1992 Efficiency Gap by 2002

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Common Assumptions:f = σ = 0.5Labor Share (1992) = 0.7g = hTarget growth: 12.6 percent p.a.

A key question influencing relative country performance is the extent to which initial differences in efficiency between countries are expected to persist or efficiencies are expected to converge. If efficiencies converge, investment needs in the currently more efficient countries--Czechoslovakia and Hungary--rise in relative terms, while the reverse is the case if efficiency catch-up is limited.

4. Conclusion

Caution needs to be used before using the production function model described to project investment requirements. Any such projection requires a heroic set of assumptions. Quantitative results are therefore bounded by large ranges. Further work on various areas such as the experience from other countries on efficiency gains, the relative productivity of Eastern European countries, different definitions of capital stock and investment and different depreciation assumptions would likely improve application of the framework provided by the model. But the limits of any such further work should be emphasized. Given that the approach assumes the application of an EC production function in Eastern Europe and assumes efficiency parameters applicable to such a function, there is inevitably little firm economic grounding for either the initial value or the subsequent movement of these parameters. Further research will not eliminate a large element of conjecture.

The advantage of the production function model described is that it provides a framework for illustrating the importance of factors which determine future capital needs in Eastern Europe. In particular, it emphasizes the crucial role to be played by efficiency improvements in determining both future capital needs and the likelihood these will be met. Thus, if average EC efficiency levels can be achieved in 10 years, growth close to the targets postulated--around 12 1/2 percent per annum for the region as a whole--is potentially achievable with investment income ratios around 30-40 percent, cumulative investment of around US$2-3 trillion and a high real rate of return to capital. The initial starting position is of less importance. Assuming a low initial capital stock--an inherited capital stock worth little in western terms--with high starting general efficiency (g), investment needs would be lower as any given U.S. dollar investment would augment capital by a proportionately larger amount. If this were the case--which evidence from east Germany could be interpreted to support--it would imply that high growth rates could be achieved with relatively low investment rates. Even in this case, however, efficiency improvements would play an important role in both generating growth and the rate of return required to attract the necessary investment. 1/ These efficiency gains could in turn be fostered by the import of western capital goods. Alternatively, a higher initial capital stock would imply, ceteribus paribus, larger investment needs and a greater role for improvements in general efficiency.

At first glance, the policy implications of the two assumptions about the starting position could differ. To achieve high growth, with a low initial capital stock, investment would appear the primary requirement while with a higher initial capital stock, improvements in efficiency would appear crucial. In practice, this distinction appears overdrawn. The prime policy requirement to improve efficiency and to promote investment is identical--namely the establishment of a flexible market-oriented economy. This requires the implementation of reform policies described in section 3 above. And, even with a relatively small initial capital stock, improvements in efficiency will play a key role in generating growth.

The policy implications of the framework described are the imperative to implement reforms such as liberalizing markets, establishing effective ownership and institution building in such areas as legal, statistical and accounting systems. These reform policies will both promote efficiency gains and investment. Direct foreign investment will no doubt play an important role in efficiency improvements. But even with rigorous reform policies, it is questionable whether the elimination of all current inefficiencies by 2002--particularly for the currently less efficient countries--is realistic. If, significant inefficiencies persist, the capital needs required to achieve the targets postulated would be much higher than the US$2-3 trillion mentioned above. It is doubtful whether, in such circumstances, these capital needs could be financed. It is also questionable whether rates of return would be sufficient to attract this level of investment. In the absence, therefore, of a near catch up to current EC levels of efficiency, the growth targets would appear unrealistic.

Assessing Eastern Europe's Capital Needs
Author: Mr. Anthony R. Boote